Fixing the Euro Zone and Reducing Inequality, Without Fleecing the Rich

What do deflation and rising inequality have in common? The answer is that we have too much of both and they threaten the nascent global recovery. The US economy is in cyclical full-steam-ahead mode, but it’s mainly benefitting the owners of financial assets – wage growth is missing. In Europe, deflation and rising inequality are combining to make a bad situation much worse.

Increasing inequality of income and wealth has occurred across the developed world for the past 30 years, with the majority of the gains from technology, globalization and deregulation accruing to a small minority in each country. Setting aside the issues of political legitimacy this raises in democracies, high and sustained levels of inequality are bad for long-run growth. This is now accepted as fact by organizations as diverse as the IMF and Standard and Poor’s.

The policy response to the global financial crisis exacerbated and entwined these trends still further. The traditional response to the problem of insufficient demand is government-led infrastructure spending. Yes, no doubt many countries would benefit from better infrastructure, and the current low cost of borrowing for governments suggests that it would be a good time to make such investments. But the recent attempt to launch a major infrastructure program in the euro zone – the so-called “Juncker plan” – illustrates that such proposals are hindered by politics, are rarely timely, and are often insufficient in scale to make a real difference to the larger economy.

In addition, rather than continue their stimulus spending, many economies began to cut back excessively, especially in Europe, which made their economies slump further. With fiscal remedies on the sidelines, monetary policy had to take up the slack. Interest rates of zero meant that central banks took to targeting asset prices – stocks and bonds – to boost spending. But the ownership of financial assets is highly concentrated and the effect was to compound the existing trends of wealth and income inequality, with muted effects on demand.

Both of these reinforcing trends have created a tax revenue problem for governments. Today, the burden of income tax is increasingly being borne by middle and upper-salary households. Those with the lowest incomes have their income supplemented by transfers, often as tax credits, while at the other end of the distribution, many of the super-rich owe their wealth to capital – which is taxed at a lower rate — not salary. With the recovery in Europe failing to materialize and wages in the US stagnant despite the improved economy, tax receipts will continue to fall, which only leads to wider deficits and more demands to cut spending.

In short, the middle is being squeezed, the top doesn’t spend enough, the bottom doesn’t earn enough, and the policy mix is fatally flawed. We need new policies.

The European central bank is close to exhausting conventional approaches – official interest rates are negative, and even large-scale asset purchases are unlikely to significantly increase private sector spending. Encouraging already stretched households and corporates to borrow more, as a way to spur recovery in the midst of deep recession, is both ineffective and negligent. So one solution suggested by a growing number of economists in Europe is for central banks to “helicopter drop” money, and directly finance private sector spending.

Milton Friedman imagined a helicopter flying over a community and dropping dollar bills from the sky. Conveniently, he assumed each household picked up an equal share. To Friedman, it was obvious that this would result in an increase in spending. All the empirical evidence on analogous policies, such as tax rebates, suggests that Friedman was correct: unsurprisingly, if you give people more money, they tend to spend it. They don’t rationally-discount it, save it all, or give up their jobs in the hope of a handout.

How could this work in practice in a modern economy? And wouldn’t it all result in hyperinflation and the end of civilization?

The simplest way to boost demand is to give power to central banks to transfer cash in equal amounts to all households. For example, the European central bank, which by law is prohibited from financing government spending, could simply credit the bank accounts of all tax-paying euro zone citizens.

Such a policy would be cheaper than the alternatives and more effective. Quantitative easing (QE) by the Fed, Bank of England and the Bank of Japan, has involved asset purchases equivalent to more than 20% of GDP. A payment of cash to Eurozone households of 3-5% of GDP would probably suffice to generate a recovery. This policy is also fairer. Each household gets the same amount of money and there is no favoring of borrowers, lenders, or owners of assets. It’s also faster and more direct than infrastructure spending.

What about inflation, or worse still, hyperinflation? These fears are emotional and fade under clear analysis. Any impact on prices would depend on how much spare capacity there is in the economy. Firms in the euro zone are desperate for higher sales; price increases would be corporate suicide in the current, intensely competitive economic environment. For Europe to have an inflation problem, there would need to be a boom first – and nothing could be further from the current reality. Still, to mitigate fears of inflation, we recommend tying the cash drops to a Taylor rule (a nominal interest rate/inflation rate target) and when the economy hits that target, the drops stop.

All central banks should be given this power, even if they do not need to use it immediately. It would provide the Fed and Bank of England with a contingency plan should their economies faced renewed shocks. In Europe it is an immediate remedy to deflation, which if it is not halted, threatens the very unity of Europe.

But even if this works, can we do more to reverse the huge increase in income and wealth inequality that makes recessions deeper and recoveries more fragile?

Substantial benefits of globalization, deregulation, and technology accrue to almost all of us, but the financial rewards appear have gone disproportionately to capital. In the United States, corporate profits as a percent of GDP are close to historic extremes and yet higher corporate investment spending has not materialized. One policy would be to tax the top more, but a better solution would be make sure that all segments of society have significant equity ownership.

One lasting consequence of the global financial crisis is a high global equity risk premium. This risk premium is a measure of the likely excess return of the stock market relative to government bonds. Sine the crisis, investors have had a strong preference for assets which are perceived as low risk, such as government debt. Combined with an expectation that interest rates will stay low for a long time, this creates a world where the cost of borrowing for most developed governments is now negative in real terms. In contrast, global equity markets are priced to deliver something close to historic long-run returns of around 5% in real terms. Even in the United States, where many correctly observe than equity valuations are above their long run averages, equity markets are still priced to beat government bonds by around 4% in real terms. This gap implies that governments have an opportunity to buy equity cheaply on behalf of the population.

We propose that governments should exploit this excess return by funding large sovereign wealth funds housed within central banks (so that politicians can’t get at the funds), financed by issuing government bonds. Alternately, the Fed and other central banks, which have trillions of dollars of “safe” bonds via QE programs, could sell these and buy global equities. Creating sovereign wealth funds along these lines would allow governments to dramatically expand the ownership of equity, without any increases in taxation.

For example, if the US government issued 30% of GDP in bonds and invested the proceeds in an index of global stocks, there would be no immediate impact on the government’s balance sheet. It would have a liability (government bonds) and an asset (equity holdings) of equal value. But over 15 years, the real value of the government bonds will be unchanged, or lower, because after inflation the yield is negative, and the value of the equities is likely to have doubled – the compounding effect of a 5% real return. The wealth created, equivalent to 30% of US GDP, could then be distributed to the poorest 80% of households. This is not alchemy. The government is simply broadening equity ownership by exploiting the shorter time horizons and risk aversion of global investors.

The politics of fiscal policy and the tools of monetary policy are out-of-date and dysfunctional. Modest innovation to address the intertwined problems of deflation and inequality is needed. Financial markets currently provide a unique opportunity for governments to acquire equity on behalf of a majority of the population. If rising job insecurity and lower wage growth is the price we must pay for globalization and technological innovation, let us at least broaden the ownership of equity so we all share the upside.

Mark Blyth is a faculty fellow at Brown University’s Watson Institute for International Studies, professor of international political economy in Brown’s Political Science Department, and director of the University’s undergraduate programs in development studies and international relations.